Timothy Taylor: A slacker of a state sales tax

The Minnesota sales tax is like a badly fitting backpack: Because the tax is not well-designed, its weight is poorly distributed and it feels heavier than necessary. As a result, it hinders the state's economy and limits options during a budget crunch.

Minnesota has the dubious achievement of a high sales tax rate that collects only a moderate amount of revenue. The current rate is 6.875 percent, of which 6.5 percent goes to the general fund. The rest is dedicated by a 2008 referendum to spending on natural resources and the arts. Only seven other states have state-level sales tax rates this high: California, Mississippi, Rhode Island, New Jersey, Tennessee, Nevada and Washington. (In Minnesota and other states, local governments add sales taxes of their own.)

The state did collect $4.2 billion from its sales tax in 2009 -- about 30 percent of total revenues. But a report last fall from the Minnesota Taxpayers Association, based on 2007 data, found that it ranks 26th among states in how much revenue is collected by the sales tax per $1,000 of personal income. How can Minnesota charge one of the highest sales tax rates but receive only middling revenues? The answer lies in what the tax doesn't cover.

For example, Minnesota is one of just five states where the sales tax doesn't cover clothing. State government economists estimate that extending the tax to clothing would raise $398 million per year.

But this just starts the list of exemptions to the sales tax. The original Minnesota sales tax -- 3 percent back in 1967 -- had 14 exempt categories. By 2009, there were 119 exemptions.

Some of the larger exemptions, for items like food, drugs,and home heating fuel, are often justified on the grounds that these necessities should be affordable to those with low incomes. But it is peculiar public policy to seek to help the 10 percent of the Minnesota population below the poverty line by giving a tax break to the other 90 percent -- rather than by targeting aid to those who really need it.

Five states -- Hawaii, Idaho, Kansas, Oklahoma and South Dakota -- apply the state sales tax to food products but offer special tax credits or rebates to those with low incomes. Another seven states have a lower sales tax for food. In Minnesota, applying the sales tax to food products would raise $699 million.

While most states do exempt prescription drugs from sales taxes, only 10 states other than Minnesota exempt nonprescription drugs. In fact, Minnesota voted to tax nonprescription drugs in 1987, but since has gradually exempted them again.

The exemption from sales tax for residential heating fuel was not part of the original sales tax in 1967 but was enacted when energy prices spiked in the late 1970s. Those who believe in taxing energy to encourage conservation should favor putting it back under the sales tax.

Taxing nonprescription drugs and residential heating fuel could raise several hundred million dollars of tax revenue, but many other exemptions from the state sales tax don't have much financial effect -- for example, exemptions for caskets, baby products, feminine hygiene products, medical devices, items sold for charity fund-raisers and others.

Admittedly, there are limits to what a sales tax should cover. For example, applying a sales tax on what is paid for housing wouldn't make sense, because the property tax covers housing.

Similarly, a well-designed sales tax will avoid business purchases, because doing so would result in what is called a "pyramid" effect, in which many goods and services could be taxed repeatedly as they are bought and sold by businesses, then taxed again when purchased by consumers. A well-designed sales tax applies only to purchases by consumers; businesses can be more reasonably taxed in other ways.

But the sales tax should be expanded to cover more of the services purchased by consumers. Back in 1967, services were a bit less than half of consumer purchases. Now, they are about two-thirds.

Some services have been under the Minnesota sales tax since the beginning, including local phone service and restaurant meals. Since then, the tax has been expanded to cover other services, including telecommunications, dry cleaning, house cleaning, lawn and garden services, and others.

However, the Federation of Tax Administrators, a nonprofit group that collects data and publishes reports on state and local taxation, compiled a list of 168 services that can be feasibly taxed. The list excludes housing, medical care, education and other services that would for one reason or another be difficult to tax. Minnesota sales tax covered only 66 of the services on this list. For comparison, Delaware, Hawaii, New Mexico, South Dakota, and Washington all have state sales taxes that cover more than 140 of these services.

Minnesota state government economists estimate that expanding the sales tax to cover more consumer services would raise $405 million. The biggest revenues come from taxing automotive repair and maintenance services ($122 million), legal services ($91 million) and personal care services ($86 million).

In spreading the weight of the Minnesota sales tax more fairly, some of the added revenue could be used to pay for lower sales tax rates or other desirable tax cuts, and some could be used to help the state through its current fiscal crunch. Thus, there may be political space to cut a deal.

On the Republican side, Gov. Tim Pawlenty recently appointed a 21st Century Tax Reform Commission. The commission issued a report last year suggesting a number of changes to business taxes, with the goal of improving Minnesota's climate for investment, innovation and growth. It suggested two ways to pay for these changes: a higher state cigarette tax, and to "extend the sales tax base to a broader range of consumer products and consumer services."

On the Democratic side, state Sen. Tom Bakk, who chairs the Taxes Committee, has proposed extending the sales tax to clothing. His plan would use the revenue to increase aid to education, to help the state budget crunch in the short term and to reduce sales tax rates in the longer term.

Of course, those businesses whose goods and services don't currently fall under the sales tax will squawk at the idea that their sales should be covered, too. But the decision not to broaden the sales tax means effectively higher taxes on everything else, while making it harder for state government to address its fiscal crunch.

Timothy Taylor is managing editor of the Journal of Economic Perspectives, based at Macalester College in St. Paul.